What is an Emergency Fund & How to Start One?

emergency fund
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44% of Americans don't have an emergency fund, which means they have no money saved up for rainy days. This is very dangerous because bad stuff like accidents and emergencies will inevitably happen.

Not having enough savings to cover those expenses means you will need to go into debt or, worse, end up bankrupt.

An emergency fund is money you put aside to help you with unplanned expenses like car repairs, home repairs, medical bills, loss of income, etc. You can start an emergency fund today by saving up small amounts until you have enough to cover 6-12 months of your necessary expenses.

In this article, I've shared a detailed look at the basics of an emergency fund, followed by a step-by-step guide on how to start one for yourself.

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The Basics of an Emergency Fund

Why do we need emergency funds? I mean, can't we just use our normal savings to take care of emergencies? Why do we need a dedicated fund for that?

Well, to help clear all your questions and doubts, I've arranged a comprehensive overview of the basics of an emergency fund, discussing its benefits, how much money you should save, when you should take money out of it, and where to keep it.

Benefits of having an emergency fund

Here's a list of benefits you can enjoy from having a dedicated emergency fund:

  • Avoid building more debt by taking a loan or asking friends and relatives for help during a financial emergency.
  • No need to dip into your investments or retirement savings when you need emergency cash.
  • Enjoy peace of mind that there's liquid money available in case of accidents or mishaps.
  • Quicker recovery from a financial setback.
  • Lower risk of going bankrupt.

Where should you keep your emergency fund

In an emergency, you need quick and hassle-free access to your savings.  This is why I strongly advise keeping your money in a high-yield savings account, where you can withdraw as much of your savings as you need right then and there.

That said, remember to open a separate account for your emergency fund.  Don't start saving in your normal account that you use every day.

That'll make it difficult to track how much you saved. You can also accidentally spend your emergency fund on non-emergencies.

How much money should you save in your emergency fund?

The exact amount of money you should have in your emergency fund depends on your income and standard of living. You can start small by creating an initial emergency fund of $1,000-2,000.

The goal is to grow the fund till it covers 6-12 months of your monthly expenses–not necessarily monthly income.  I strongly advise business owners and people with a variable income to create an emergency fund that covers 12 months of expenses.

People with a more secure job with consistent and stable income should be able to manage by saving 6 months of expenses.  Also, avoid over-saving in an emergency fund.

Remember that the money is kept in a savings account which rarely delivers high enough interest rates for it to grow. Once you have built an emergency fund, allocate extra savings into a retirement account or invest in stocks.

When to use your emergency fund

An emergency fund, as the name suggests, should only be used during an emergency. This includes:

  • Car breaking down.
  • Income loss because of sickness or injuries.
  • Medical bills not covered by your insurance.
  • Accidents around the house or your store.
  • Getting laid off.

Overall, suppose an unfortunate event happens and stops or hinders your daily routine or regular lifestyle, causing emotional, physical, or financial stress.

In that case, you can use your emergency fund to solve that problem.  That said, never use your emergency fund for a downpayment on a new house, planning a vacation, or even getting repairs if it isn't essential.

7 Steps to Starting an Emergency Fund

Knowing the importance and benefits of having an emergency fund, you might want to build one. That's great news! But how and where to start?

I completely understand how difficult it can be to start and maintain an emergency fund. The hardest part is being responsible enough with your income to set aside some money every month.

However, to help you overcome all the hurdles, I've put together a step-by-step guide on how to start an emergency fund.

  1. Make a budget for your monthly expenses. Budgeting will help you track how much money you need each month. It can also show you where your money is going, so you can cut out the unnecessary stuff and focus on your savings. 
  2. Determine your emergency fund goal. This should be around 6-12 months of your monthly expenses.
  3. Break up the goal into smaller chunks. An emergency fund is a large corpus of money that might make it seem unachievable initially. Instead of focusing on saving tens of thousands of dollars, focus on saving your first $1,000-2,000. That should help keep you motivated and make the task easier.
  4. Use bank bonuses to jumpstart your savings. As you're looking to open a new account for your emergency fund, search for banks offering cash incentives for opening new savings or current accounts. 
  5. Use cash back apps to save more money. There are many cash-back apps on the market that you can use to save a few dollars off purchases which you can then put towards your emergency fund.
  6. Save extra and unexpected incomes. Just like unfortunate financial emergencies, you'll also encounter fortunate financial blessings. For example, you could win the lottery, get inheritance money, win cash gifts or bonuses, and so on. When you get this extra cash, save it for the rainy days.
  7. Make your contributions automatic. I'd advise setting up an automatic deposit to ensure you stick to building your emergency fund and don't back out. 

Key Takeaways

An emergency fund is a cash backup that you build to help you during times of financial crisis. This should be large enough to cover 6-12 months of your monthly expenses.

You should also keep it inside a savings account, not in CDs or bonds, so you can easily access your money during emergencies.

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